Cisco's Journey Between Growth and Value

Erik Kobayashi-Solomon: Hi, my name is Erik Kobayashi-Solomon. I'm one of the editors of Morningstar's OptionInvestor, and today it's my great pleasure to welcome Grady Burkett who is the associate director of technology research here at Morningstar.

Grady, thanks for coming.

Grady Burkett: Thanks for having me, Eric.

Kobayashi-Solomon: So, a couple of months ago, I wrote an options investment piece on Cisco. At the time, you were just transitioning into coverage of Cisco and since then, there have been a ton of things that have happened with the company. Can you just catch us up with some of the big happenings?

Burkett: Absolutely. I initiated coverage on Cisco right as they reported fiscal 2Q, so that was in February, and obviously it was a disappointing quarter. The stock sold off about in the mid-percentages--14%, 15%--on the backs of some disappointing earnings, and more importantly, a disappointing outlook.

Essentially, there are couple of things going on with Cisco. Part of it is weakness in its government business, but probably more importantly there is a weakness in some of its core businesses, where Cisco has been very strong for a long period of time, and so switching in particular is an area of weakness for the company.

Kobayashi-Solomon: But just even aside from what their business has been doing, they also announced their first dividend about that time as well, right?

Burkett: Absolutely. So ... on the back of some of these weak earnings report and weak outlook, you saw management start to engage in some activities that suggest that it realizes some of its issues with size and some of its competitive positioning, and so you saw Cisco on the back of the earnings announcement, introduce a new chief operating officer, Gary Moore, to help realign and restructure the management team. You saw them initiate a $0.06 per share per quarter dividend, which equated at the time to about 1.5% yield or $1.4 billion in annual cash outlays.

Kobayashi-Solomon: The other thing that I did, which was one of our favorites, was they killed Flip. I just couldn't wait for them to kill Flip actually.

Burkett: Right, and when we've looked at the consumer space as a segment that Cisco shouldn't be playing in over the long run, and so they killed Pure Digital. They ... had been developing "umi," which is a home video-teleconferencing service and equipment, that they pulled back out of the consumer space and just reintegrated that technology back into collaboration business.

And so ... these were the initial steps that Cisco started to demonstrate ... after its 2Q results that were positive on the margin.

Kobayashi-Solomon: So, one other things that I picked up, and that I was really happy about, was actually Chambers, the CEO, John Chambers, admitted, "look we're not going to grow at 20% or high-teens percent forever. It looks like our growth is going to be slower." And this is a big admission for him, I think.

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Burkett: Right. So, Cisco had been targeting 12% to 17% annual growths for some period of time, and investors have been skeptical of ... their ability to achieve those targets. So in some of their commentary after the quarter and during the quarterly conference call, they were much more focused on the next few quarters in the near-term versus the long-term, and so to us, that's ... a positive change in thought process for management in our view, as well. So, we model Cisco's long-run growth rates of 7% to 8%, which we think is more realistic for a $40 billion company. We will get more clarity on Cisco's long-run operating targets in August and September, when they report fiscal Q4, and then have their financial analyst conference.

Kobayashi-Solomon: So, it's generally obvious, even to John Chambers, that their growth is slowing. Do you think that there is some kind of a clientele effect now, that some of the investors who were interested in a growth stock or a momentum story, that they are piling out of the stock and maybe it's about time for value investors to start getting more interested in it? If so, do you think, where are we in that process?

Burkett: So shareholder sentiment is obviously the most challenging thing to try to access and analyze, and so we spend most of our time focusing on the business fundamentals, but when we talk to shareholders, institutional shareholders, it is clear that the growth investors are less interested in the stock, and the value investors are interested in the stock. However, the value investors want different things than the growth investors. So, growth investors want you to grow in the double-digits, want these tech firms to grow in the double-digits, whereas value investors are more focused on returns on invested capital, return of capital to shareholders, and management stewardship of the business. So, right now it feels like some value investors are starting to maybe dip their toes in the water, and so you saw Berkowitz take a position, Tweedy, Browne took a position recently, and you're starting to see these types of investors look at this business as a viable investment option, given the valuation.

However, until they get some clarity from management that they are going to be very committed to returning a significant portion of their cash flows to investors and not go out and spend on low-return businesses, you really are not going to see that complete shift in sentiment that you want to see. So, that's where we're at now, in my view.

Kobayashi-Solomon: So let's talk a little bit about the valuation. The stock has really been hit hard lately. When I recommended it, it was actually a covered call strategy, and the stock was trading closer to $19. Now it's trading kind of closer to $15. I wonder if some of that price movement, if some of that discounting of the valuation, has to do with the problems in Europe right now. There is a lot of fiscal weakness in European governments, and I know Cisco has a pretty large presence in the government services side.

Burkett: So for investors with a shorter-term time horizon, who are thinking about what are next year's revenues going to look like, I think the weakness in federal is certainly an issue that Cisco is going to have to navigate, and all the network and equipment vendors are blaming some of the weakness on federal budgets. So, Brocade reported some weakness in the federal side, and we are hearing it from a number of tech firms, and so ... this isn't really a Cisco-specific issue. It just seems they have been most vocal, and then this compounded with some of their other issues has caused the stock really to be under pressure.

Over the long run ... in our view, the bigger issues facing Cisco are competitive pressure in some of these core markets and then to your point, reallocating the portfolio to businesses that are high return and away from businesses that are low return, where they really have no competitive advantage.

So in our view, probably the number one issue that this company faces over the next 18 to 24 months is how they position their switching portfolio, which is 30% of revenue, to compete against some of these new threats like Hewlett-Packard and Juniper, which are probably the two primary threats that we see emerging that could really cause further pressure on the business.

Kobayashi-Solomon: So let's dig into the competitive pressures a little bit more. One of the things that has bothered me about Cisco is they are starting to look at data center business as well. It looks like [Cisco], IBM, Hewlett-Packard, they are all big pigs and they are all at the same trough. And I wonder if there's going to be enough slop for all of the pigs of that trough. What do you think?

Burkett: I don't know that I would quite use that analogy, but the point is absolutely correct. All these large vendors, I would probably throw IBM out of that bucket, IBM is definitely more focused on its services and software businesses. I think IBM would be content to let the hardware vendors beat it out in networking and storage and servers, for the most part, in low-end servers.

But certainly with Cisco and HP and Dell and some of these other vendors, as you've seen their core markets mature, they've looked to other markets to grow. So, you've seen Dell make acquisitions in the storage market, you've seen HP make acquisitions in most storage and now networking with 3Com, and you've seen Cisco moving to servers with its unified computing platform.

Part of this is just a function of naturally maturing markets and tech companies looking for growth, but part of it is the way that technology is evolving such that companies are looking for integrated solutions to handle some of the growing traffic flows. We are doing this conference on video for instance, and that consumes a significant amount of bandwidth and requires new technologies in storage and computing, and so part of this is natural.

And that is one of the risks that we see for Cisco going forward. Cisco has to compete on a variety of fronts, and one of them is the systems integration front, where you've got HP, who can provide the systems integration, the consulting services, the servers, etc.--kind of soup to nuts--versus Cisco, which really just has the ... networking assets and now the server assets. And ... that's why we view HP as a meaningful threat for Cisco and actually in our model when we're modeling out Cisco's revenues and profits over the next five years, we expect market share losses for HP, and so we model in 12 points of share losses in Ethernet switching from Cisco mostly accruing to HP.

Burkett: That's our expectation over the long run. We think the switch market's gross margins will be under long run pressure relative to historical norms, and we think there will be some shift in market share from Cisco to HP, particularly in the mid-market where HP is most competitive, and price is a more meaningful differentiator.

Kobayashi-Solomon: Let's just jump back to a moment to what you were saying about growth. It seems that one problem that tech firms have--especially Cisco--it really owns switches. The switches were very high return on invested capital business. That business is not going to grow as quickly--you're even modeling market share losses.

So, now management is faced with the decision, OK--how do we grow our business? Well, we acquire something, like they acquired ... Pure Digital. Well, a business like that doesn't have as high a profitability. It doesn't have as high a return. So, how do you think about ... that balance between growth and profitability, and where do you think Cisco is going to come down on this?

Burkett: So, first of all regarding acquisitions, we are generally skeptical that companies can acquire their way into creating shareholder value. So, we typically take a skeptical viewpoint on any acquisitions, but particularly with tech companies.

The acquisitions that Cisco has made, the markets it has entered, that have not strengthened its competitive advantage and are dilutive to gross margins, are acquisitions that we would be extremely disappointed if we saw these going forward. So, Pure Digital is an example of that. PostPath, which is a web-based e-mail service that they actually bought for $200 million a few years back and recently shuttered is another example of that.

However, you do have businesses, like their server business, which may be 40% gross margins on the surface (that's our estimate), which is below corporate average. But when you look at the fact that it strengthens their competitive positioning selling into the enterprise space, the enterprise IT space, and allows them to increase the breadth of their product portfolio, even through it's lower gross margin, it still should contribute to the gross profit line and also help strengthen their position. So, certainly you are not going to see Cisco earn the types of returns on capital that it earned pre-Scientific-Atlanta and pre-Linksys, but to the extent that they divest some of the really low margin, non-core businesses and allow the mix shift into some of these lower-margin but still core businesses selling into their core customer space, you'll still see a pretty good business. I mean this is still a business that generates returns on invested capital, certainly in the high-teens then depending on how you think about the asset base, could be even higher.

Kobayashi-Solomon: Well, thanks very much for talking to us about Cisco, Grady. I appreciate it.

Burkett: Thanks for having me, Eric.

Kobayashi-Solomon: Thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you'll find many more great ideas about how to manage your risk using options.

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